If a country exports more goods, the importing country will have a higher demand for the currency of the exporting country so as to meet its obligation. The value of the currency of the exporting country will therefore appreciate. The opposite is the case if a country imports more goods than exports.
2. Political Stability
Unsuitable political climate will make the citizens lose confidence in their currency. They would therefore wish to invest or just buy the currency of the other countries they deem to be stable. In so doing, the demand for currency of more political stable countries will appreciate as compared to those of politically unstable countries.
3. Inflation rate differential (purchasing power parity theorem)
Parity between the purchasing powers of two currencies establishes the rate of exchange between the two currencies. When inflation rate differential between two countries changes, the exchange rate also adjusts to correspond to the relative purchasing powers of the currencies.
The purchasing power theorem states that the:
% E(f) = I (h) – I (f) x 100 I (f) + 1
Where % E (f) is the percentage change in the direct quote I (h) is the inflation rate in the home market
I (f) is the inflation rate in the foreign market.
Illustration
Assume that the direct quote between the $ and £ is £1 = $ 1.5 and that the inflation rate in UK is 10% and the inflation rate in the US is 6%
Required
Compute the % change in the direct quote and determine the new exchange rate.
% E (f) = 0.06 – 0.1 x 100 = -3.64%
0.1+ 1
The New Direct Quote
£1 = £1.5*(1 – 3.64%)
£1 = $1.4454
4. Interest Rate Parity (International Fisher Effect)
This theory states that differences in interest rate in different market can cause a flow of funds from markets with low interest rate to markets with high interest rates.
The international fisher effect can be explained as follows:
%E (f) = I (h) – I (f) x 100 1+ I (f)
% E (f) = is the % change in direct quote.
I (h) = is the interest rate in the home market.
I (f) = is the interest rate in the foreign market.
Illustration
Assume that the direct quote is deuchemark is DM 1 - $ 0.5 while the general interest rate in US is 6% and general interest rate in Germany is 3%.
Required:
Compute the percentage change in direct quote and the new exchange rate.
Solution
The term balance of payment refers to a system of government accounts that catalogues the flow of economic transactions between the residents of one country and the residents of other countries. It is therefore the fund flow statement.
Continuous deficit in the balance of payments is expected to depress the value of a currency because such deficit would increase the supply of that currency relative to its demand.
6. Government Policies
A national government may through its Central Bank intervene in the foreign exchange market, buying and selling its currency as it sees fit to support its currency relative to others. In order to promote cheap export, a country may maintain a policy of undervaluing its currency.
1.4 TYPES OF EXCHANGE RATES (a) Fixed Exchange Rate
This is that rate at which the value of a currency remains stable vis-a-vis other currencies for a long period of time. These rates of exchange are fixed by the Central Bank through the process of pegging the currency concerned e.g. if the currency is pegged to a Dollar, then its value remains fixed to the value of the dollar and will move with movement in the value of the dollar.
Advantages of Using Fixed Exchange Rates
i. It stabilizes the export proceeds and therefore it may stimulate exports for the period in which it is fixed.
ii. Foreign investors gauge the return on their investments in local currency vis-a-vis their own currencies. A fixed exchange rate will assure these investors of a stable return on their investment which may induce foreign investors, thus increasing the inflow of foreign exchange to the country.
iii. It enables the government to meet its development plans whose budgets are set in local currencies but may be financed by foreign loans and aid.
iv. It may keep inflation under control because the prices of imported goods will remain stable as long as the exchange rate is fixed. This is particularly true for imported inflation.
v. Long term investment plans can be worked out with substantial accuracy and may minimize budget deficits with their negative effects.
(b) Floating Exchange Rate
When the rate of exchange of a currency is floating, it is left to move in response to different forces (especially the balance of payments). It is left to be determined by the forces of demand and supply of foreign currencies of a given currency.
This rate may discourage investment by foreign investors as they are uncertain about the return to be earned on investment made under floating rates of exchange. It may also discourage export trade and may increase inflation rates.
1.5 EXCHANGE RATE EXPOSURE
The extent to which a firm is exposed or vulnerable to fluctuations in exchange rate is referred to as the exchange rate exposure and can be perceived in three different ways:
Transaction exposure
This defines the foreign exchange rate risk in terms of the impact of exchange rate movement on the firm‘s future cash flows. This type of exposure arises from an obligation to either accept or deliver foreign currency at a future date. The most important transactions leading to transaction exposure are accounts receivable and accounts payables denominated in foreign currency.
Translation Exposure
Translation exposure defines exchange rate risk in terms of the impact of exchange rate movement on the financial statement of the firm. When a business is organized as several separate corporations, then financial statements must be filed on a consolidated basis so as to give shareholders concise and complete information as to the financial position and the operating performance of the firm as a whole. When subsidiary operate in a foreign country then major complications occur in consolidation process. This problem arises from the fact that financial statements of the foreign subsidiary are usually in a currency which is different form that of the parent company. The foreign currency must be converted into the home currency before accounts can be consolidated. Translation exposure therefore is the extent to which multinational firms consolidated financial statements are affected by the need to convert its foreign subsidiary accounts to the home currency. As the value of the exchange rate fluctuates, so would be the value of the foreign subsidiary.
Economic Exposure
Economic exposure defines exchange rate risk as the total impact on all the cash flow of the firm (both contractual and non-contractual) It is broader than the other types of exposure and may be considered to be the overall impact of the foreign exchange fluctuations on the shareholders wealth. It affects both the companies that enter into foreign currency transactions and those that do not.
MANAGEMENT OF TRANSACTION EXPOSURE